Equity markets continued their rough start to the year with the S&P 500 falling 3.14%, the NASDAQ losing 3.34%, the Dow Jones Industrial Average slumping 3.53%, the Russell 1000 Value “outperforming” with a 1.35% loss & the Russell 1000 Growth shedding 4.33% during the month of February. A combination of soaring inflation & geopolitical tensions in Eastern Europe were the main contributing factors to February’s decline in the equity markets as investors braced for the Federal Reserve (“the Fed”) to raise interest rates for the first time in 3 years & continuing uncertainty surrounding Russia’s invasion of Ukraine.
February Stonemark Market Commentary
The Energy sector (+6.37% in February & +26.54% YTD) was the only S&P 500 sector to end the month of February is positive territory while the Communication Services sector (-6.98% for February & - 12.92% YTD) was the worst performing sector. The rally in the Energy sector came as investors continued to monitor the situation in Ukraine, which has sent the price of oil skyrocketing as oil traders braced for the possibility that Russia’s oil exports could be the next of their assets to be slapped with international sanctions.
4th Quarter Earnings Wrap-Up & 1st Quarter Earnings Preview
The end of February essentially brings a conclusion to the earnings season for the 4th quarter of 2021. According to FactSet, 76% of S&P 500 companies have beat their earnings estimates & 77% of S&P 500 companies have reported better than expected revenue for the 4th quarter of 2021. The Information Technology (88%), Industrials (85%) & Healthcare (83%) sectors had the most companies beat their earnings estimates while the Materials (57%), Communication Services (59%) & Utilities (68%) had the fewest number of companies beat their earnings estimates. Looking at the broader market as a whole, the graphic below from CFRA shows full-year earnings for the S&P 500 coming in at $209.53, which would be a 47% increase on a year-over-year basis from the dismal earnings we saw in 2020.
Despite the majority of companies beating their earnings & revenue estimates in the 4th quarter of 2021, many companies did warn that 2022 could be a different story based off of what companies discussed on their 4th quarter earnings calls. According to FactSet, 65 S&P 500 companies issued negative EPS guidance for the 1st quarter of 2022 while just 29 companies issued positive EPS guidance for the 1st quarter. Furthermore, FactSet is forecasting 1st quarter 2022 earnings growth to come in at 4.8% on a year-over-year basis, which would be the lowest EPS growth rate since the 4th quarter of 2020. Unsurprisingly, 356 of the S&P 500 companies cited the single largest concern for moving forward is inflation. The last time we saw this many companies so concerned with inflation came in 2010 where 74% of the S&P 500 companies indicated that inflation was going to be the single greatest headwind for corporate earnings in the near future.
Looking at the graphic above, as of the market close on February 28th, 2022, the S&P 500 was trading at a price-to-earnings multiple (“P/E multiple”) of 19.61x, which is above the 5- & 10-year average P/E multiples of 18.6x & 16.8x, respectively, but well below the 27x P/E multiple that the S&P 500 was trading at back in September & December of 2020. If we assume 2022 S&P 500 earnings come in in-line with CFRA’s estimates of $224.10 & assuming a 20x P/E multiple, we get a year-end price target of 4,482 on the S&P 500 or just 2.5% above the index’s February 28th closing price of 4,373. A year-end level of 4,482 for the S&P 500 would equate to a 6% decline on the index for the year. We knew that there would be multiple contraction this year as rising interest rates can’t justify multiple expansion. With that said, in order for the S&P 500 to get much higher than the current levels & post a positive return for the year, we will need to see earnings results beat expectations by quite a bit, which could be a difficult task given the ongoing supplychain issues, increasing input costs & surging commodity prices.
Russia Invades Ukraine & the Impact on the Markets
After weeks of rumblings that Russia was seeking to retake control of the former Soviet Union nation of Ukraine, the chatter surrounding Russia’s “immanent” invasion of Ukraine came to an unfortunate reality as Russian forces invaded Ukraine on February 24th. As is typically the case when a war or conflict breaks out, the S&P 500 fell by 1% intraday on February 24th, 2022, when news of the invasion first broke. However, the S&P 500 managed to close in positive territory & looking at the graphic below, history shows that the S&P 500’s price action shouldn’t come as much of a surprise.
While any war or conflict inevitably brings uncertainty & volatility into the equity markets, of the last 9 major wars dating back to World War II, the S&P 500 was negative just twice, one month following the start of the conflict. Furthermore, there were only three instances (World War II, the Iran-Iraq War & the War in Afghanistan) in which the S&P 500 was negative one year after the conflict started. That being said, past performance does not guarantee future results & given the fragility of equity markets, should the Russia-Ukraine conflict escalate significantly, equity markets would almost certainly come under selling pressure. Should Russian President, Vladimir Putin, take control of Ukraine & continue his territorial conquests further West, he would be knocking on the doors of Poland, Slovakia, Hungary & Romania, all of which are NATO members. Under Article 5 – Collective Defense of NATO, an attack on one NATO ally is considered an attack against all NATO allies, which would mean that the United States, as a NATO member, would be obligated to come to the defense of its allies & would be brought into the conflict. For now (and we seriously hope it remains this way), the U.S. remains removed from the actual hand-to-hand fighting & has imposed severe sanctions on Russian assets. Here some of the sanctions currently levied against Russia in response to its invasion of Ukraine:
The U.S. Secretary of State, Anthony Blinken, announced that it was barring Russian financial institutions, including the Russian Central Bank, from making any transactions in U.S. dollars.
The U.S. also imposed sanctions on the state-owned Russian Direct Investment Fund, which has been described as a “slush fund” for Putin & his inner circle.
Officials believed that the Russian Direct Investment Fund was what Putin was expecting to rely on during the invasion of Ukraine.
Additionally, the U.S. said that it would cut off 13 major state-owned companies from raising money in the United States.
The massive energy company, Gazprom & Russia’s largest financial institution, Sberbank, are among the 13 companies that will not be prohibited from raising money in the United States.
Additionally, President Biden announced sanctions that would block the export of certain technologies, which would severely inhibit Russia’s ability to advance its military & aerospace sectors.
In a statement from the White House, the sanctions would be on “semiconductors, telecommunication, encryption security, lasers, sensors, navigation, avionics & maritime technologies.”
Finally, the U.S. announced that it would be banning all Russian oil & gas imports.
The U.K. said that it would “phase out” all Russian oil imports by the end of 2022.
The EU, which gets 25% of its oil & 40% of its gas from Russia, has said that they will switch to alternative supplies & make Europe independent from Russian energy “well before 2030”.
The U.S., the EU, the United Kingdom & Canada have banned certain Russian banks from the Society for Worldwide Interbank Financial Telecommunication (“SWIFT”) network.
The SWIFT network is a secure network that facilitates payments amongst 11,000 financial institutions in roughly 200 countries.
The U.K. is preventing Sberbank from clearing payments in British Sterling & three more Russian banks, Otkritie, Sovocombank & VEB will all face a “full asset freeze”.
The U.K. also announced that it is banning Russia’s national airline, Aeroflot, as well as private jets chartered by Russian individuals from flying to its airports.
The U.K. joins the U.S., the EU & Canada as countries who have banned all Russian flights from flying to their airports.
Germany has halted the certification of the Nord Stream 2 Gas Pipeline.
Nord Stream 2 is a 1,234-kilometer-long natural gas pipeline that is being built & operated by Nord Stream 2 AG, a subsidiary of the Russian state energy company, Gazprom.
Nord Stream 2 runs through the Baltic Sea & would allow natural gas to flow from Russia to Germany.
Switzerland announced that it was freezing the assets of certain individuals, effective immediately.
President Vladimir Putin, Prime Minister Mikhail Mishustin & Foreign Minister Sergey Lavrov are among the individuals whose assets will be frozen.
France announced that it will be targeting financial assets, real estate, yachts & luxury vehicles that belong to certain Russian individuals.
Japan announced that they would be limiting transactions with Russia’s central bank & would be freezing Putin’s assets.
Australia said that it would begin “imposing further sanctions on oligarchs whose economic weight is of strategic significance to Moscow & over 300 members of Russia’s parliament.”
Australia has also imposed travel bans for several members of Russia’s Security Council.
New Zealand is prohibiting the export of goods to the Russian military & security forces.
So, what does this all mean for the markets? On the equity side, aside from the initial selloff when the markets opened on February 24th, equities have seemingly weathered the initial headlines quite well. In fact, the S&P 500 opened at 4,155 on February 24th & closed at 4,373 on February 28th – a 5.2% rally to end the month. Additionally, some individual companies such as Apple, Coca-Cola, Pepsi, McDonald’s & Starbucks have announced that they are suspending operations in Russia. While closing physical locations & halting exports of their products to an entire country will negatively impact their top-lines, most of these companies derive a very small portion of their total revenue from Russia. As a result, we don’t think that the financial impact on companies who are suspending their operations in Russia will be too significant. That being said, we have recently started exiting positions that we owned who did generate a portion of their revenues from Russia & have added this as a criterion to look for when researching new positions to add to our portfolios.
Turning to the fixed income & commodity markets, the story is similar to what we have seen in the equity markets. Yields on 10-year U.S. Treasury securities plummeted from 1.96% to 1.82% in February’s final 3 days of trading. Remember, the yield & price of fixed income securities move inversely of each other so when 10-Year U.S. Treasury yields fall from 1.96% to 1.82% in a matter of 3 days, that means that those securities are being bought quite aggressively. This is the reaction that we would expect when a war breaks out as fixed income securities, especially U.S. Treasuries, are typically thought of as a safer investment than equities. Looking at the commodities markets, the price of West Texas Intermediate (“WTI”) crude oil rallied 3.45% in the final 3 days of February while the price of brent crude rallied 2.96% over the same time period. Additionally, WTI gained 8.58% & brent crude added 12.68% in the month of February, which indicates that the Russia-Ukraine conflict only added fuel to the already strong rally that we were seeing in the oil markets.
The Fed & Interest Rates
We spent quite a bit of time covering inflation, the Fed & interest rates in January’s Monthly Commentary, so we won’t go too in depth on this matter again. However, given the fact that March’s upcoming Federal Open Markets Committee (“FOMC”) meeting is a “live” meeting, meaning that they are expected to raise interest rates, combined with recent developments abroad & another hot consumer price index (“CPI”) print for the month of January, we wanted to briefly revisit this topic. Fed Chairman, Jay Powell, has made it abundantly clear that raising interest rates is on the very near horizon & that the Fed could raise interest rates at every meeting for the rest of the year. Should the Fed raise rates at each of its remaining 7 FOMC meetings, that would bring the Federal Funds (“Fed Funds”) target rate to the 1.75-2.00% range. However, that is assuming that the Fed only raises interest rates by 25 basis points (“bps”, 1% equals 100bps), which is typically the increments that the Fed raises rates in. That being said, Powell & other voting members of the FOMC have said in previous meetings that they would not rule out a 50bps rate hike at one or more of their meetings if the economic conditions warrant doing so. Looking at the graphic below, it appears as though market participants are expecting the Fed to raise rates by 50bps at least once this year, with traders expecting the Fed Funds rate to end the year at the 2.25-2.50% target rate (green bar in the graphic below).
The graphic above might be a little confusing, but it is essentially a visual representation of where Fed Fund futures traders believe the target range will be in the coming months. For example, by the September meeting (yellow bars), traders expect the targeted range for the Fed Funds rate will be at 1.50-1.75%. At a quick glance, the graphic above is alluding to the potential of a 50bps hike at the June meeting. As it stands now, traders are implying a 67% probability that the Fed will raise rates by another 25bps to a 0.50-0.75% targeted Fed Funds rate at the May FOMC meeting (blue bar). However, the next FOMC meeting is in June & based on the graphic above, traders are forecasting a 57% chance that the targeted Fed Funds rate will be 1.00-1.25%, which would be that 50bps rate hike that Powell & the Fed have said they are willing to make. It is important to remember that the Fed does not determine the probabilities in this graphic but rather it is traders who participate in the Fed Funds futures market who determines these probabilities so these need to be taken with a grain of salt.
With the Fed set to start raising interest rates as soon as their March meeting & the ongoing Russia-Ukraine conflict, we expect the volatility that we have seen in the equity markets to start 2022 to continue for the foreseeable future. As we mentioned earlier in this commentary, rising interest rates make it difficult to justify the S&P 500 trading at the elevated P/E multiples that we have seen over the last two years. With CFRA forecasting full-year earnings for the S&P 500 to come in at $224 & assuming a P/E multiple of 20x, this would equate to a year-end price target for the S&P 500 of 4,480 – roughly a 2.4% gain from February’s closing price of 4,373. Between record-setting inflation numbers, the Fed raising interest rates, continuing supplychain issues & the Russia-Ukraine conflict, it is difficult to argue that 2022 will match the annual returns in the equity markets that we have seen the last two years. With that being said, we will continue to monitor any & all market-moving catalysts. Furthermore, we will remain diligent with regards to positioning our portfolios in order to weather any sort of volatility to the best of our abilities.
As always, please feel free to reach out with any questions or concerns.
Stay Safe & Stay Healthy!